Ashley Percival, CFP®
Very few people (if any) enjoy thinking about the inevitability of death. This probably explains the reluctance of people to seriously consider their life insurance needs and why this vital aspect of financial planning is often neglected.
It is important to first determine whether you need life insurance.[i] If you have no dependents and enough assets to cover your debts and the cost of dying (funeral costs, executor’s fees etc.), then insurance is an unnecessary cost for you. You would be better of spending your money on something more useful.
If you have dependents or significant debts that outweigh your assets, then you likely will need life insurance. The question is: which kind of insurance should you get?
Whole life insurance
Whole life insurance is a life insurance policy which is guaranteed to remain in force for the insured’s entire lifetime, provided required premiums are paid.[ii] If you want to protect your family against the destruction of your business or estate taxes after your death, whole life insurance should be considered.
Term insurance is a type of life insurance policy that provides coverage for a certain period of time, or a specified ‘term’ of years. If the insured dies during the time specified in the policy and the policy is in force, then a death benefit will be paid.[iii] If your main concern is to protect your family against a loss of your income, term insurance is the way to go.
Another not so well known option is what is referred to as a death income policy. This type of policy gives you the option to choose different income levels and payment periods to suit the needs of your dependents and beneficiaries. So, for example, you could set the lump-sum cover so that it pays off your home loan and then have two income benefits that pay your spouse and your child. The income can be linked to inflation and paid for a term – for example, until your spouse reaches the age of retirement or for the rest of his/her life.[iv]
How much life cover is enough?
There are rules of thumb that suggest that cover equal to fifteen times or twenty times your annual salary is sufficient. Unfortunately, these rules of thumb do not take families’ unique circumstances into account. You should be more precise and think about how much money your family would need to cover your income as well as debt.
Factors you should consider:
1.Loss of primary income. At their core, life insurance policies are designed to cover the loss of income to your family as a result of your death. The amount of life cover you choose should therefore be enough to at least fulfil this requirement and to ease your family’s immediate financial burden. In the longer-term, your life insurance benefit can be used to cover essential life expenses for your surviving family members, such as your children’s education.
2. Dependents and their needs. The amount of life cover you need also depends on the number of dependants you have and what their individual needs are. For example, your spouse may rely on you for income, or he/she may have an independent income that they contribute to the household each month. If you have several children, your life insurance policy should aim to ensure that they would all be adequately cared for in the short and medium term.
3. Covering personal debts if you own a business. Look at how the running of your business will be affected should you pass away. For example, if you have enough life insurance to cover your personal debts, your surviving family members can continue to run your business fairly seamlessly without needing to take money out of it to cover your remaining debts.[v]
Life insurance needs analysis
There are several good needs analysis software solutions that calculate how much life cover a person needs. These software solutions consider everything from provision for children’s schooling to estate duty and executor’s fees. I strongly recommend the use of needs analysis software and that you ask a professional to assist you.
A simple estimation
To estimate[vi] the amount of life cover you need, the following calculation may be used:
Let’s say you’ve calculated that your family needs R50 000 per month gross of tax (R600 000 per year) for household expenses, school fees, insurance, vehicle payments, spouse’s retirement contributions etc.[vii] in the event of your death. The amount is needed for the next 20 years (when you would have retired) and must keep pace with inflation.
What is the capital amount needed to generate the required income of R600 000 per year increasing with inflation each year for 20 years?
If you invest the policy proceeds (capital) in a low-to-moderate risk investment, the maximum annual withdrawal you can make is about 5% of capital.[viii] 100 divided by 5 equals 20. The number 5 refers to the withdrawal rate and 20 to the number of years that income is required for. The required income of R600 000 multiplied by 20 equals R12 Million.
R12 Million should generate income of R50 000 per month (R600 000 per year) increasing with inflation each year for 20 years. Let’s say debt such as your home loan, estate duty, executor’s fees etc. is R2 Million. This amount is added to the R12 Million.
Therefore, estimated life cover required is R14 Million.
The replacement of income calculation can be tested with a pre-programmed excel spreadsheet.[ix]
|End of Year||After Allowing for Inflation||% of First Year Income|
|Market Value||Annual Annuity|
|1||R 11,665,426||R 600,000||100%|
|5||R 10,142,389||R 600,000||100%|
|10||R 8,071,256||R 600,000||100%|
|15||R 5,797,220||R 600,000||100%|
|20||R 3,300,403||R 600,000||100%|
|30||R 626,099||R 127,521||21%|
The annuity payments increase with inflation each year. It is reflected as R600 000 up until year 20 as the buying power of the annuity payments remain constant up until year 20. If you need inflation adjusted income for more than 20 years, you should increase life cover or reduce the annual withdrawal rate to 4% or lower.
It will give you piece of mind to know that that your loved ones are taken care of if something happens to you. Make sure to review your insurance needs at least once a year or when your circumstances change.
You don’t buy life insurance because you are going to die, but because those you love are going to live. – Unknown Author
[vi] The calculation of estimated life cover needed should not be construed as financial advice. Seek professional advice before making any decisions.
[vii] Make sure that you include all expenses and make provision for unforeseen expenses.
[viii] Based on industry guidelines.